1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 7 The Pricing of Risky Financial Assets

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-2 Learning Objectives Understand what risk aversion means and the resulting necessity of compensating risk averse investors with higher expected returns to hold risky assets Calculate the basic measures of risk See how diversification can reduce or eliminate all nonsystematic risk in a portfolio of investments

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-3 Introduction Risk is a double-edged sword—It complicates decision making but makes things interesting Understand how investors are compensated for holding risky securities and how portfolio decisions impact the outcome A financial asset is a contractual agreement that entitles the investor to a series of future cash payments from the issuer Value of a security is dependent on nature of the future cash payments and credibility of the issuer in making those payments

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-4 Introduction (Cont.) Every risky security must compensate investor for –Delayed payment of cash flow –Uncertainty over those future cash flows –The expected return to the investor takes both issues into account Ultimate objective is to determine the equilibrium expected return on a risky security

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-5 A World of Certainty Individuals are predictable and live up to contractual agreements on financial securities In this case, the same interest rate is applicable to each and every loan –Charge more—people would not borrow –Charge less—lenders would be deluged with requests for funds All securities are prefect substitutes for each other—sell at the same price and yield the same return

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-6 A World of Certainty (Cont.) In this world, the key decisions influenced by the riskless rate of interest are consumption versus saving –The individual investor would forgo consumption for a minimum riskless rate of return –Depends on the individual’s preference between current and future consumption –Is the rate high enough to persuade individual to forgo consumption in favor of saving –The higher the rate, the more people will elect to save for future consumption

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-7 Consequences of Uncertainty and Risk Aversion In contrast to a “perfect world,” investors face uncertainty Outcome may be better or worse than expected Risk aversion –Investors must be compensated for risk –Will hold risky securities if higher expected returns will offset the undesirable uncertainty –Trade-off of higher return versus risk is subjective and different for every individual

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-8 Consequences of Uncertainty and Risk Aversion (Cont.) Portfolio diversification –A strategy employed by investors to reduce risk –Holding many different securities rather than just one with the highest possible return In real life, most people are risk averters since they hold diversified portfolios

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-9 Consequences of Uncertainty and Risk Aversion (Cont.) An Aside on Measuring Risk –Probability Distribution—A listing of the various outcomes and the probability of each outcome occurring –Expected return—A weighted average of the different outcomes multiplied by their respective probability –Standard deviation The square root of the sum of the squared deviations between the actual outcomes and the expected outcome

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-10 Consequences of Uncertainty and Risk Aversion (Cont.) An Aside on Measuring Risk (Cont.) –Standard deviation (Cont.) Standard deviation is a good representation of risk—evidence to suggest that outcomes are symmetric and have a normal distribution When comparing securities, the one with the largest standard deviation is the riskier If returns and standard deviations between two securities are different, the investor must make a decision between the tradeoff of the expected return and the standard deviation of each

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-11 Principles of Diversification Modern Portfolio Theory—Asset may seem very risky in isolation, but when combined with other assets, risk of portfolio may be substantially less—even zero When combining different securities, it is important to understand how outcomes are related to each other –Procyclical—Returns of two or more securities are positively correlated indicating they move in same direction –Countercyclical—Returns of two or more securities are negatively correlated-move in opposite directions –Combining a procyclical and countercyclical securities would greatly reduce the risk of the portfolio

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-12 Principles of Diversification (Cont.) Therefore, the important consideration of adding another security is the asset’s contribution to the total portfolio’s risk Covariance—A measure of how asset returns are interrelated with each other

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-13 Principles of Diversification (Cont.) As long as assets do not have precisely the same pattern of returns, then holding a group of assets can reduce risk If the returns of each security are totally independent of each other, combining a large number of securities tends to produce the average return of the portfolio

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-14 The Risk Premium on Risky Securities The standard deviation of returns is a good measure of risk for analyzing a security However, it is a relatively poor measure of the risk contribution of a single security to an entire portfolio This depends on the covariance of returns with other securities Non-systematic Risk of a portfolio is diversified away as the number of securities held increases

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-15 The Risk Premium on Risky Securities (Cont.) Market portfolio—A widely diversified portfolio that contains virtually every security in the marketplace –Investor earns a return above the risk-free rate that compensates for the co-movement of returns among all securities, rather than the risks inherent in every security –The risk of the market portfolio is less than the sum of each security’s risk because some of the individual variability tends to cancel out

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7-16 The Risk Premium on Risky Securities (Cont.) Systematic Risk relates to the risk of an individual security in relation to the movement of the entire portfolio –The risk premium that investors demand will be in proportion to the systematic risk of the security –Riskier security must offer investors higher expected returns –Extra expected return on a risky security above the risk-free rate will be proportional to the risk contribution of a security to a well-diversified portfolio